Pussycat or tiger?

PUBLISHED : Friday, 02 November, 2007, 12:00am
UPDATED : Friday, 02 November, 2007, 12:00am

How should the mainland's new sovereign wealth fund, China Investment Corp (CIC), spend its US$200 billion? Its launch has concentrated the minds of foreign investors and western politicians, who are increasingly uncomfortable with the murky investment strategies and motivations of sovereign wealth funds. The fund is not the biggest, but many are run by the governments of East Asian exporters and Middle Eastern oil-producing countries.

For Chinese policymakers, where and how CIC should invest are very much open questions. Basically, they felt compelled to do something about the country's unnecessarily bountiful foreign-exchange reserves (now at US$1.4 trillion). The fuel behind mainland China's exports is its surplus savings that domestic consumption cannot fully absorb. But because this high savings rate is structural, exports will continue to be larger than imports for some time. Beijing, though, is worried that the export earnings and excessive reserves build-up will fan inflation at home and protectionism abroad.

Thus, CIC was hastily created to help let out some steam. To be fair, a number of government think-tanks studied other nations' sovereign wealth funds. It is widely believed that Singapore's and Norway's were singled out as role models.

But CIC cannot wholly mimic either Temasek Holdings or Norges Bank Investment Management (NBIM). As a small city state, Singapore is not perceived as a threat by the west and, in any case, it simply does not have enough investment opportunities domestically. Norway's objective is to invest wisely proceeds from its own vast illiquid assets - namely, oil - over time. In a way, the US$370 billion that the NBIM manages is almost like an endowment fund for the future welfare of its country's citizens. Leaving aside the NBIM's excellent record of accountability and transparency, there is no way for CIC to match Norway-like welfare objectives for 1.3 billion Chinese.

There are many challenges for CIC. What would be the reaction in the west if the shadowy CIC tries to take over a Wall Street bank? The point is that many foreigners will view Chinese entities as opaque no matter what kind of ownership structures they have. Thus, it would be in the mainland's best interests to keep CIC modest in size and pursue a passive investment strategy.

Even then, in the wake of its investment in Blackstone, a US private-equity group whose share price dived soon after its New York listing in June, there has been a barrage of criticism about whether Beijing knows what it is doing. There is a fundamental clash between the extreme risk-averse nature of most state companies and an investment approach that tries to balance risk and return. Civil servants are often rewarded for not making mistakes and punished for taking too much risk. This low risk tolerance will pose a very serious challenge for CIC.

Talent is another critical issue. CIC has hinted at the possibilities of bringing in experienced investment professionals but has stopped short of outsourcing a significant portion of its asset to professional fund managers.

In fact, many state-owned mainland companies employ a few foreign experts purely for image. This will probably be the case for CIC, too, with key investment decisions made by the finance ministry and the National Development and Reform Commission.

Although copying Norway's NBIM may be like 'drawing a tiger based on a cat', as a Chinese saying goes, CIC's minders should pay heed to at least a couple of lessons from it. For example, the NBIM limits maximum ownership in any firm to a 5 per cent stake and no investment is allowed in Norwegian companies. Indeed, it would make a lot of sense to rule out CIC investment in Chinese firms to enhance its political independence.

Given all the pitfalls awaiting CIC, the best solution for Beijing to counter an excess build-up of foreign reserves is to give domestic investors more choice outside the mainland (for example by allowing 'through-train' investment in Hong Kong stocks) and in foreign companies (by making A-share listing feasible for foreign companies on the mainland). That way, the reserves will not get too big and unwieldy.

Steven Sitao Xu is the Economist Intelligence Unit Corporate Network's director of advisory services in China